Dividend ETFs may be first ‘fiscal cliff’ casualty

Commentary: With taxes up, high-quality matters over high-income

By

Conradde Aenlle

LONG BEACH, Calif. (MarketWatch) — It seems as though everyone is aware of the so-called fiscal cliff, but few are scared of it.

Indeed, the buoyancy of the stock market lately suggests that traders expect a compromise in Congress on the tax increases and government spending cuts that are widely expected to cause a recession if implemented.

Why are investors ignoring the ‘fiscal cliff’?

(3:17)

It's strange that some investors don't seem to be doing anything to protect themselves in case Washington doesn't act to head off the ‘fiscal cliff.’ Justin Lahart argues the point on Markets Hub. Photo: Reuters.

What they may not realize is that any compromise is likely to include tax increases and spending cuts — barely distinguishable from no deal at all. Stocks could take a hit either way, and with tax rates due to rise more on dividend payments than on other forms of income, companies and sectors known for high-dividend yields could be hurt most.

Investors, who otherwise showed little trust in the market, no matter how high it went, coveted the perceived safety of companies disbursing large, regular payments.

A study by investment researcher Morningstar Inc. found that $10,000 invested in mid-2005 in high-yield, high-quality stocks would have grown to slightly more than $16,000 by the end of 2011. The same amount invested in the broad stock market would have barely reached $12,000.

The combination of nervous markets and few alternative assets that produce healthy income has made dividend stocks a crowded trade, cliff or no cliff. And if we do go off the fiscal cliff or just down a gentler fiscal slope, after-tax dividend income is bound to decline — possibly by far more than investors realize.

Dividend dilemma

Although it can be hard to notice sometimes, corporate directors are rational individuals. When dividends are taxed at higher rates than other forms of distribution to shareholders, history has shown, companies are less inclined to pay them.

During periods when the highest tax rates on dividend income and long-term capital gains were the same, such as from the mid-1980s through the late 1990s and again in the last decade, the number of companies that paid dividends was fairly stable, according to data from S&P Dow Jones Indices. During the intervening period, when dividends were taxed at higher rates than long-term gains, a situation set to recur in January, there was a sharp fall in the number of dividend-paying companies.

The pattern could be more muted this time, a study by WisdomTree Investments argues, because dividend payments have been declining for decades as a proportion of corporate earnings. Maybe, but it’s unlikely to vanish completely, so when factoring in the frothiness in high-yield stocks and the outright decline in after-tax income that’s likely in the new year, it’s tough to make a compelling case for equity-income funds or funds specializing in high-yield sectors.

Solid footing

Instead of investing in stocks that pay fat dividends, it may make more sense to consider why dividend-paying companies are so appealing — other than the payments themselves — and look for ways to invest in ones possessing such qualities.

A recent post in David Merkel’s Aleph Blog offers a place to start by suggesting that the financial wherewithal to pay dividends, through healthy cash-flow generation, makes a company worth owning and that actually paying them is almost beside the point.

“I don’t so much believe that dividends have value, as [that] many companies that pay dividends have value,” Merkel wrote. “Free cash flow is valuable and results in dividends, buybacks and reinvestment in the business.”

In other words, buy stocks of high-quality companies that add value for shareholders regardless of how they choose to make that value available. One way for fund investors to implement this sensible notion is through exchange-traded vehicles that track the Morningstar Wide Moat Focus Index, which comprises stocks of companies that the research firm’s analysts judge to have a sustainable competitive advantage in their industries.

The Elements Wide Moat Focus exchange-traded note
WMW, -0.88%
, though lightly traded, has exhibited stellar performance since it was introduced just over five years ago, rising nearly 50%, compared to a loss of about 10% for the S&P 500. Rival Market Vectors Morningstar Wide Moat Research ETF
MOAT, -0.85%
, trading only since August, has much heavier volume and has modestly beaten the S&P 500 over its much more limited lifespan.

Judging by the trading on Wall Street and the rhetoric in Washington, big dividend payers could be the first group pushed off the fiscal cliff in the weeks ahead. The rest of the market may not be far behind, but funds like these may be able to come through the drop in better shape or avoid it altogether.

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